9-1 Chapter 9 Capital Asset Pricing Model. 9-2 It is the equilibrium model that underlies all modern financial theory Derived using principles of diversification.

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Presentation on theme: "9-1 Chapter 9 Capital Asset Pricing Model. 9-2 It is the equilibrium model that underlies all modern financial theory Derived using principles of diversification."— Presentation transcript:

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9-1 Chapter 9 Capital Asset Pricing Model

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9-2 It is the equilibrium model that underlies all modern financial theory Derived using principles of diversification with simplified assumptions Markowitz, Sharpe, Lintner and Mossin are researchers credited with its development Capital Asset Pricing Model (CAPM)

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9-4 Information is costless and available to all investors Investors are rational mean-variance optimizers There are homogeneous expectations Assumptions Continued

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9-5 All investors will hold the same portfolio for risky assets – market portfolio Market portfolio contains all securities and the proportion of each security is its market value as a percentage of total market value Resulting Equilibrium Conditions

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9-6 Risk premium on the market depends on the average risk aversion of all market participants Risk premium on an individual security is a function of its covariance with the market Resulting Equilibrium Conditions Continued

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9-7 Figure 9.1 The Efficient Frontier and the Capital Market Line (CML)

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9-9 The risk premium on individual securities is a function of the individual security’s contribution to the risk of the market portfolio An individual security’s risk premium is a function of the covariance of returns with the assets that make up the market portfolio Return and Risk For Individual Securities

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9-15 The Index Model and Realized Returns To move from expected to realized returns—use the index model in excess return form: R it = α i + β i R Mt + e it where R it = r it – r ft and R Mt = r Mt – r ft α i = Jensen’s alpha for stock i The index model beta coefficient turns out to be the same beta as that of the CAPM expected return-beta relationship

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9-16 Figure 9.4 Estimates of Individual Mutual Fund Alphas,

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9-17 The CAPM and Reality Is the condition of zero alphas for all stocks as implied by the CAPM met –Not perfect but one of the best available Is the CAPM testable –Proxies must be used for the market portfolio CAPM is still considered the best available description of security pricing and is widely accepted

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9-19 Econometrics and the Expected Return- Beta Relationship It is important to consider the econometric technique used for the model estimated Statistical bias is easily introduced –Miller and Scholes paper demonstrated how econometric problems could lead one to reject the CAPM even if it were perfectly valid

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9-21 Black’s Zero Beta Model Absence of a risk-free asset Combinations of portfolios on the efficient frontier are efficient. All frontier portfolios have companion portfolios that are uncorrelated. Returns on individual assets can be expressed as linear combinations of efficient portfolios.